The Aix Group’s first publication, in 2004, addressed the economics of a “Two State” permanent agreement. The Group analyzed the agreement in the context of the political discussions at that time which focused on the Road Map for Peace. The Road Map (December 20, 2002 version) had very little treatment of economic issues. Its three phases are defined principally in political terms:
- Phase I involved ending terror and violence, normalizing Palestinian life, comprehensive security reform, Israeli military withdrawals to the pre-Intifada positions of September 2000, cessation of settlement activity and free Palestinian elections.
- Phase II aimed at the establishment of a Palestinian state with attributes of sovereignty, provisional borders and a new constitution.
- Phase III assumed the conclusion of a permanent status agreement and the creation of a sovereign Palestinian state.
In the year 2004, the Aix Group published a paper entitled “The Economic Road Map (ERM)” which assessed future policy options in specific economic areas. The paper focused on the final status agreements and the creation of a sovereign Palestinian State (Phase III of the ERM). The Group chose to focus on the permanent status since it believes that the economic content of the previous phases of the ERM dealing with security and the foundations for statehood can only be determined correctly if a clear vision of final status arrangements exists first. We called this approach “reverse engineering” and have continued to follow this non-gradual strategy since.
In accordance with the ERM, the paper assumes the emergence of a “Two State” solution embodying Palestinian economic sovereignty, unambiguous borders and the conduct of economic relations in a spirit of cooperation and mutuality. The group’s economic vision of permanent status is based on economic arrangements that will seek a convergence of Palestinian living standards with those of Israel and promote independence in economic policy-making while acknowledging economic interdependency.
The ERM assessed and recommended future policies in trade, labor, fiscal, monetary policies and investment.
When it comes to the choice of a trade regime, there are a number of options, the main ones being a Customs Union, a Free Trade Area (FTA) and a Most Favored Nation (MFN) regime.
The FTA between a Palestinian state and Israel is likely to be feasible and efficient, as well as to offer advantageous development opportunities. A bilateral free trade agreement would provide the Palestinian state open access to the Israeli market, which will continue to be a key trading partner. At the same time, it will allow the Palestinian state to diversify its trade relations and implement development policies conducive to economic growth and prosperity. A FTA model will be most efficient if it is accompanied by a friendly system of Rules of Origin which would minimize negative impacts on trade.
The FTA regime recommended by the Group requires cooperation between the parties in the following areas:
- First, the FTA regime should allow for a degree of asymmetry – whereby for a temporary period Palestine can implement certain trade restrictions on imports from Israel on a MFN basis. The purpose of this would be to stimulate Palestinian economic growth and domestic employment, as was the case with the 1975 agreement between Israel and the EEC.
- Second, the Israeli and Palestinian governments would need to discuss and agree upon:
- Rules of Origin
- Cooperation in export promotion
- Third, the guiding principles for trade relations should be those enshrined in the World Trade Organization (WTO) agreements, including the dispute settlement mechanisms which are applicable between members.
- Fourth, supervising the implementation of the agreement should be entrusted to a Joint Israeli–Palestinian Economic Committee, which should be empowered to recommend revisions to the agreement where appropriate and mutually agreeable.
- Human Capital and Labor Mobility
The group recommends the establishment of designated passages across which labor flows will be unencumbered, but subject to regulation through taxes and/or permits.
The regulation of labor flows will need to address both sides’ macroeconomic interests as well as their security needs. Some of these policy measures should start in Phase I such as:
- designated passages to regulate and supervise labor flows;
- creating a Uniformity in Working Conditions agreement to include common rates of income, other labor taxes, and identical regulations;
- de-monopolization of the labor market through granting work permits to individual workers and allowing permit holders to seek jobs in Israel freely;
- favoring Palestinian workers: A surcharge should be imposed on non-Palestinian workers on account of the negative externalities resulting from their presence in Israel.
- Fiscal Policy
Under a FTA, each country would run an independent international customs policy, but would not impose duties on goods originating in Israel/the Palestinian state (with certain exceptions as defined under the agreement).
To minimize smuggling, indirect tax policy needs to be closely coordinated, and VAT and other indirect tax rates (excises, purchase taxes) should only diverge marginally, if at all.
Double taxation should be avoided since this would discourage cross-border economic activity. Accordingly, there is a case for applying lower income tax rates to Palestinian workers in Israel as compared to those applicable to Israelis or other foreign workers. Alternatively, Israel should continue to remit to the Palestinian state a large portion of the income tax it levies on Palestinians working in Israel, as well as any social security deductions.
Once Phase III is achieved, it is vital that Palestinian tax administrative capacity be built-up so as to avoid revenue losses that the Palestinian budget can ill afford. Capacity building programs of this kind are often given low priority; the cost of neglect in this case would be immense for the Palestinian state as well as Israel, and the stability of both tax systems would be threatened.
The Group recommends that Israel and the Palestinian state would need to share information, hold regular consultations and coordinate indirect taxation policies in order to avoid smuggling, enhance efficiency in collection, avoid double taxation on incomes and minimize fiscal leakage.
- Monetary Policy
The Aix Group recommends that the restrictions embedded in the Paris Protocol preventing the Palestinian Monetary Authority from issuing Palestinian currency be lifted in Phase II (whether or not the Palestinian Authority (PA) then decides to create a new currency). At present, the Palestinian Authority does not receive revenue from issuing and circulating a currency, and this raises the possibility of the PA sharing the revenue derived from the issuance of Israeli Shekels while the current currency system continues.
In order to facilitate bilateral trade and investment, payments and transfers for current or capital transactions should be kept free of restrictions (as is the case today). Correspondent relations between banks on both sides should also be facilitated, especially insofar as check clearing and reciprocal arrangements for letters of credit and letters of guarantee are concerned.
A sovereign Palestinian state can decide either to use one or several foreign currencies as legal tenders, or to introduce its own currency. In the latter case, the state also needs to decide what exchange rate regime to adopt, whether it is a fully flexible exchange rate, an adjustable peg (linked to a foreign currency or a basket of foreign currencies), or a currency board. As long as the current currency regime continues, several foreign currencies will continue to circulate and be used, including the New Israeli Shekel (NIS).
The new Palestinian state could choose to implement monetary and exchange rate policies fully independently, but coordination with Israel is obviously advisable in view of the interdependence of the two economies. In addition, the two central banks should consult over the supervision of branches and subsidiaries operating within each other’s jurisdiction (the supervision of such branches and subsidiaries would have to be conducted in accordance with the international prudential rules defined by the “Basle Accord”). Another area of coordination should be the payment system and the existence of clearing houses.
The Group recommends that both countries accord one another’s investors and investments national treatment – with some exemptions in cases that bear upon special national interests. The future economic agreement should permit full repatriation of revenues and income, should preclude the possibility of double taxation and should address expropriation and regulatory matters pertaining to facts and disputes created after its entry into force. Donors can contribute to cross-border investment by establishing funds that can be used to build equity positions in Palestinian firms and to create joint ventures with Palestinian partners, as well as by continuing to offer risk insurance and guarantees to investors.
There is undoubtedly potential for greater Palestinian trade in services with Israel, Arab countries and the rest of the world. Growth in this area is best approached through incentives for Israeli investors to take equity positions and enter into joint ventures with Palestinian partners. This will require the elimination of discriminatory treatment, consistent with the obligations of the WTO Agreement on Trade-Related Investment Measures (TRIMs).
Industrial estates may also offer opportunities for investment. These estates could be located along the border with Israel or within the Palestinian state; to attract Israeli investors, they would need to offer a rock-solid security environment.
Areas of Cooperation and Joint Institutions
The introduction of these new economic arrangements will require intensive bilateral cooperation. This would be facilitated in particular by the establishment of a Joint Israeli-Palestinian Economic Committee, as well as by regular dialogue at experts’ level to exchange views on all areas of economic policy. The establishment of an Israeli-Palestinian Development Fund should also be considered; this institution could play a major role in encouraging a variety of joint activities, such as industrial estates, business ventures for domestic and external markets, tourism projects and joint public/private infrastructure initiatives.
The transitional period requires, above all, a vigorous effort to stimulate Palestinian economic recovery. This can only be done by restoring movement and predictability in transactions. Three basic ingredients are required to achieve this:
- unencumbered flow of goods across borders and within the West Bank and Gaza;
- unencumbered flow of persons within the Palestinian Territories, coupled with the flow of workers to Israel which regains some stability and predictability;
- The continued uninterrupted flow of fiscal transfers from Israel to the Palestinian Authority.
The meaning and operation of a Palestinian state with provisional borders, as envisaged under Phase II, needs thorough exploration since it will serve as the precursor to full economic independence. Phase II arrangements must realistically be based on a “Paris Plus” formula – that is, the full implementation of the modified Paris Protocol.
Phase II arrangements should include measures that ensure territorial viability, i.e. the creation of internal contiguity and the inception of economic control over external borders. Steps should be taken to denote emerging sovereignty, including the right to issue currency and the granting of observer status in the IMF, the UN, the World Bank and the WTO. Attention should also be given to the development of institutions that will reinforce cooperation and resolve disputes.